Final Flashcards
Define finance
Finance is the study of how and under what terms savings (money) are allocated between lenders and borrowers.
Explain what is involved in the study of finance
- Finance is about what terms and through what channels the allocations are made.
- Whenever funds are transferred, a financial contract comes into existence, and these contracts are called financial securities.
What are the major sectors of the economy?
The four major sectors of the economy are government, business, households, and non-residents.
How do the three channels function in transferring money?
Money is transferred from lenders to borrowers through the following three channels:
- Financial intermediaries transform the nature of the securities they issue and invest in
- Market intermediaries that simply make the markets work better,
- Non-market transactions in which the market is not involved.
What are the basic type of financial instruments?
Debt (loans) and equity (ownership)
How are the financial markets divided?
Primary and secondary markets
What are financial securities?
A financial contract that exists when funds are transferred
What is net worth (equity)?
The difference between the value of what is owned and owed
What is the goal of the firm?
To create value for the firm’s shareholders by maximizing the price of the existing common stock
How can we increase/decline stock price?
Good financial decisions will help increase stock price and poor financial decisions will lead to a decline in stock price.
What is the role of management?
Management serves as an arbitrator and moderator between conflicting interest groups or stakeholders and objectives
How do we moderate employer/shareholder liabilities?
- Creditors, managers, employees and customers hold contractual claims against the company
- Shareholders have residual claims against the company
What are the three basic issues addressed by the study of finance?
Decisions
- Capital budgeting decision
- Capital structure decision
- Operating decision
What does operating decision look at?
How to manage cash flows arising from day-to-day operations
What do capital structure decisions looks at?
How will we get the money?
What do capital budgeting decision look at?
What are we doing to do with the money?
What are the principles of finance?
- Cash Flow Is What Matters (when is the cash flow coming in?)
- Money Has a Time Value
- Risk Requires Reward
What does “Money Has a Time Value” look at?
- A dollar received today is worth more than a dollar received in the future
- Since we can earn interest on money received today, it is better to receive money sooner rather than later.
What does “Cash Flow Is What Matters” look at?
- Accounting profits are not equal to cash flows.
- It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books.
- Cash flow, and not profits, drive the value of a business and keep it afloat.
*We must determine additional cash flows when making financial decisions.
What does “Risk Requires Reward” look at?
- Risk is the uncertainty about the outcome or payoff of an investment in the future.
- Rational investors would choose a riskier investment only if they feel the expected return is high enough to justify the greater risk.
How do we find future value?
Opening balance x % interest (the amount of times) = ending balance
How do we measure present value?
PV = FV / (1+interest rate) ^number of years
How do we measure the NPV (Net Present Value)?
- Calculate the present value of cash inflows,
- Calculate the present value of cash outflows,
- Subtract the present value of the outflows from the present value of the inflows.
If the NPV is negative, is the project acceptable?
NO! Only when positive and zero
What are some typical cash outflows?
- Initial Investment (cash need to purchase asset)
- Incremental operating costs
- Repairs and maintenance of new equipment
- Additional investment in inventory
What are some typical cash inflows?
- Incremental revenues
- Reduction of operating costs
What does cost of capital mean?
A firm’s minimum required rate of return
What are real assets?
Tangible things owned by persons and businesses
- Residential structures and property (personal assets)
- Major appliances and automobiles (consumer durables)
- Office towers, factories, mines (business assets)
- Machinery and equipment
What are financial assets?
What one individual has lent to another
* Consumer credit
* Loans
* Mortgages
What is the NBSA and what is it’s role?
National Balance Sheet Accounts
Role = to collect financial data on the major agents in the financial system and then track the borrowing and lending between the agents
What are the three functions of money?
- Medium of exchange
- Standard of value
- Store of value
What is medium of exchange?
How transactions are conducted:
Something that is generally acceptable in exchange for goods and services. In this function, money removes the need for double coincidence of wants by separating sellers from buyers.
What is standard of value?
How the value of goods & services are denominated:
Something that circulates and provides a standardized means of evaluating the relative price of goods and services.
Reason for why an item is priced that way
What is store of value?
How the value of goods & services are maintained in monetary terms:
The ability of money to command purchasing power in the future.
What are the different channels of money transfer?
- Financial intermediaries
- Market intermediaries
- Non-market transactions
Describe financial intermediaries
Transform the nature of the securities they issue and invest in (bank, insurance company) → investing funds on behalf of others
Describe market intermediaries
Make the markets work better, do not change the nature of the transaction (i.e. real estate broker, stock broker)
Describe non-market transactions
In which the markets are not involved (i.e. lending money to your sibling so they can buy a car)
What is intermediation?
The transfer of funds from lenders to borrowers (bringing parties together)
What is the first channel?
Direct intermediation – the lender provides money directly to the borrower (non-market transaction, family or friend)
What is the second channel?
Direct intermediation through a market intermediary – the borrower, uses a market intermediary to help find suitable lenders
What is market intermediary?
An entity that facilitates the working of markets, to assist with transactions and bring borrowers together (mortgage brokers, insurance brokers, stockbrokers)
What is the third channel?
Indirect intermediation, direct claim on financial institution – the financial intermediary lends the money to the ultimate borrowers but raises the money itself by borrowing directly from other individuals (principal transactions, principal on its own behalf)
What is retail markets?
When market intermediaries help individuals
What is institutional markets?
When market intermediaries help financial intermediaries
What is the fourth market?
Trades made directly between investors (usually large institutions), without involving brokers or dealers, operates through privately owned automated systems
What are the 4 important factors of the financial system?
Banks, insurance companies, pension funds, mutual funds
How do banks function in the financial system?
Take in deposits and make loans
How do insurance companies function in the financial system?
Take in insurance premiums and pay off when an incident occurs
How do pension funds function in the financial system?
Take in contribution and provide pension payments after plan members retire
How do mutual funds function in the financial system?
Simply act as a “pass through” for individuals, providing them with a convenient way to invest in the equity and debt markets.
What is a credit crunch?
A situation in which financial intermediaries have to raise the cost of their loans by a significant amount because of their own inability to gain profit
What is crown corporations?
Government-owned companies that provide good and services needed by Canadians
What are the different types of equity instruments?
Common shares and preferred shares
What are common shares?
Part ownership in a company, usually gives voting rights on major decisions affecting the company
What are preferred shares?
Ownership that has a higher claim on assets and earnings than common stock has
Payment in dividends
Criteria of common stocks
- The common stockholders are the owners of the corporation’s equity
- Voting rights
- No specified maturity date and the firm is not obliged to pay dividends to shareholders
- Returns come from dividends and capital gains
- On liquidation of company, common stockholders are last in list for company assets, only after creditors, bondholders, and preferred shareholders are paid out
Criteria of preferred stock
- Equity instruments
- Usually entitle the owner to fixed dividend payments that must be made before any dividends are paid to common shareholders
- Generally do not have voting rights in the company
- Have characteristics of both bonds and stocks
- On liquidation of the company, preferred stockholders will be paid out before common stockholders (but after creditors/bondholders)
- First pick
What are the financial markets?
- Primary and secondary markets
- Money and capital market
- Organized exchanges and over-the-counter
What is a primary market?
Involve the issue of new securities by the borrower in return for cash from investors (or lenders) [i.e. new securities are created]
What is a secondary market?
Provide trading (or market) environments that permit investors and buy and sell existing securities
What are exchanges or auction markets?
Secondary markets that involve a bidding process that takes place in a specific location
What are money market securities?
Short term debt instruments (maturities less than one year i.e. T-bills)
What are capital market securities?
Include debt securities with maturities greater than one year (i.e. bonds & equity securities) & equity securities
What are dealer or over-the-counter markets?
Secondary markets that do not have a physical location and consist of a network of dealers who trade directly with one another
What is market capitalization?
The total market value of the common equity of an entity
What is bootstrap financing?
Entrepreneur supplies funds, prepares business plan, searches for initial outside funding
What is seed-stage financing?
Venture capitalists provide to funds to finish development of the concept
What is early-stage financing?
Venture provide financing to get the business up and running
What is latter-stage financing (mezzanine financing)?
Typically includes one to five additional stages
Final stage of financing sources
Venture capitalists exit by selling to a strategic buyer, selling to a financial buyer, or selling stock to the public
Financing sources
- Bootstrap financing
- Seed-stage financing
- Early-stage financing
- Latter-stage financing
- Venture capitalists exit
Criteria of Bootstrap financing
- Entrepreneurs starting a business
- The initial “seed” money usually comes from the entrepreneur or other founders.
- Entrepreneur fighting out for themselves
- Other cash may come from personal savings, the sale of personal assets, loans from family and friends, use of credit cards.
- The seed money, in most cases, is spent on developing a prototype of the product or service and a business plan.
- Usually lasts 1 to 2 years
What is venture capital?
- Venture capitalists are individuals or firms that help new businesses get started and provide much of their early-stage financing.
*Individual venture capitalists or angel investors, are typically wealthy individuals who invest their own money in emerging businesses at the very early stages in small deals.
What are 3 reasons why traditional sources of funding don’t work for a new business?
- High degree of risk
- Types of productive assets (businesses without tangible assets will struggle)
- Information asymmetry problems (entrepreneurs don’t have the expertise)
What else can venture capitalists bring to the table?
- Provide advice
- They provide counsel for entrepreneurs when a business is being started and during early stages of operation
- Give them an equity interest in the company (want partial ownership)
How do venture capitalists reduce their risk?
Tactics to reduce risk:
* funding the ventures in stages
* requiring entrepreneurs to make personal investments (want to stretch you thin to ensure their investment succeeds)
* syndicating investments
* in-depth knowledge about the industry
What is syndication?
- It is a common practice to syndicate seed- and early-stage venture capital investments.
- Syndication occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalists.
What is the exit strategy?
- Venture capitalists are not long-term investors in the companies, but usually exit after a period of three to seven years.
- Every venture capital agreement includes
provisions identifying who has the authority to make critical decisions concerning the exit process. - Timing (when to exit)
- The method of exit
- What price is acceptable
What is initial public offering?
Selling shares to the public
Three ways in which venture capital firms exit venture-backed companies:
- Sell to a strategic buyer in the private market
- Sell to financial buyer in the private market (private equity firm- does not expect to gain from synergies).
- Initial Public Offering: selling common stock in an initial public offering (IPO).
Disadvantages of going public
- High cost of the IPO itself
- Costs of complying with ongoing SEC (provincially) disclosure requirements
- Transparency that results from this compliance can be costly for some firms
Advantages of going public:
- Amount of equity is larger
- Additional equity can be raised at a low cost
- Can fund growing business without giving up control
- Creates secondary market for trading
- Easier to attract top management and motivate current managers
- Doesn’t have to be 100% of the business
What are the steps to complete an IPO?
- A firm will need the services of investment bankers, who are experts in bringing new securities to the market.
- Investment bankers provide three basic services when bringing securities to market–
1. Origination (getting shares ready)
2. Underwriting (risk-bearing part)
3. Distribution (selling shares)
What is organization in terms of IPO?
- Gives the firm financial advice and getting the issue ready to sell (can the company withstand issuing shares?)
- The investment banker helps the firm determine whether it is ready for an IPO
- Once the decision to sell stock is made, the firm’s management must obtain a number of approvals
- File a registration statement with Securities Exchange Commission
What is underwriting in terms of IPO?
The risk-bearing part of investment banking
- Firm Commitment Basis - agreeing on an offer price to sell the shares for, guaranteeing a certain price to the startup owner (investment bank buying stock from startup company for specific price)
- Best-Efforts Basis - making no guarantees to sell at a specific price, not confident in company
What are the three basic costs associated with issuing stock an IPO?
- Underwriting Spread
- Out of pocket expenses
- Underpricing
What is underwriting spread?
Difference between the proceeds the issuer receives and the total amount raised in the offering
What is out of pocket expenses?
Includes: other investment banking fees, legal fees, accounting expenses, printing costs, travel expenses, SEC filing fees, consultant fees, and taxes.
What is underpricing?
Difference between the offering price and the closing price at the end of the first day of the IPO
What is underwriting syndicates?
- To share the underwriting risk and to sell a new security issue more efficiently, underwriters may combine to form a group called an underwriting syndicate.
- Participating in the syndicate entitles each underwriter to receive a portion of the underwriting fee as well as an allocation of the securities to sell to its own customers.
Is determining an offer price easy or hard?
One of the investment banker’s most difficult tasks is to determine the highest price at which the bankers will be able to quickly sell all of the shares being offered and that will result in a stable secondary market for the shares.
What is a due-diligence meeting and when does it take place?
- Before the shares are sold
- Used to protect their reputations and to reduce the risk of investors’ lawsuits in the event the investment goes sour later on.
What happens after the due-diligence process?
- The underwriters and the issuer determine the final offer price in a pricing call.
- The pricing call typically takes place after the market has closed for the day.
- By either accepting or rejecting the investment banker’s recommendation, management ultimately makes the pricing decision.
What is a general cash offer?
A general cash offer is a sale of debt or equity by a public company that has previously sold stock to the public
What are the two types of sale of a general cash offer?
Competitive sale and negotiated sale
What is competitive sale?
After the origination work, underwriters bid competitively to buy the issue & sell to investors
What is negotiated sale?
The issuer selects the underwriter at the beginning of the origination process and works closely with them to design and sell the issue.
Differences between private and public, (private criteria)
Priv:
1. Cheapest source of external funding for smaller firms and firms of lower credit standing
2. Bootstrapping and venture capital financing
3. Occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals
4. When market condition are stable, often have to transition from pub to priv
Benefits from private placements:
- Private lenders are more willing to negotiate changes to a bond contract.
- If a firm suffers financial distress, the problems are more likely to be resolved without going to a bankruptcy court.
- Other advantages include the speed of private placement deals and flexibility in issue size.
Main disadvantage for private placements:
Private placements involves restrictions on the resale of the securities
What is a “dividends policy”?
A firm’s overall policy regarding distributions of value to stockholders
What is a dividend?
- Something of value that is distributed to a firm’s stockholders on a pro-rata basis.
- Can involve the distribution of cash, assets, or something else, such as discounts on the firm’s products that are available only to stockholders.
What happens when a firm distributes value through a dividend?
It reduces the stockholders’ investment in a firm by returning some of that investment to them
What are the 4 types of dividends?
- Regular Cash Dividend
- Extra Dividend
- Special Dividend
- Liquidating Dividend
Criteria of a regular cash dividend
- Most common form.
- Generally paid on a quarterly basis (forever if they can, with small increases)
- Common means by which firms return some of their profits to stockholders.
- Set at a level that management expects the company to be able to maintain in the long run, barring some major change in the fortunes of the company.
Criteria of an extra dividend:
- Often paid at the same time as regular cash dividends.
- Not a ton of commitment, or causing the expectation you’re staying forever
What is a special dividend?
- One-time payment to stockholders
- Are larger than extra dividends and occur less frequently
What is a liquidating dividend?
Paid to stockholders when a firm is liquidated
What is the last day to purchase a stock with an upcoming record date, and still receive the dividend?
3 days before
Stock repurchases criteria
- When a company repurchases its own shares, it removes them from circulation.
- Stock repurchases are taxed differently than dividends.
What is a tender offer?
Company offers to buy shares back (for specific price, more than market price, OR sending out notif to repurchase shares from shareholders and gives them various price asking how much people will sell)
What is an open market repurchase?
Company buys from investors willing to sell (limitations to how much can be done)
Two types of tender offer
Fixed price and dutch auction
What is a fixed price?
Management announces the price that will be paid for the shares and the max number of shares that will be repurchased. Interested stockholders “tender” their shares by responding with how many shares they are willing to sell.
What is a dutch auction?
Management announces the number of shares it would like to repurchase and offers it at a series of prices above the market price, to see which price is best to allow for the required shares to be purchased
What is a stock dividend?
- Doesn’t involved distribution of value or change the value of the company
- When a company pays a stock dividend, it distributes new shares of stock on a pro-rata basis to existing stockholders.
What is a stock split?
- Think of it as a division of each share into more than one share
- Can send a positive signal to investors about the outlook that management has for the future, leading to a higher stock price
Management has just declared a 3-for-1 stock split. If you own 12,000 shares before the split, how many shares will you own after the split?
4000
What questions should managers consider when selecting a dividend policy?
- Over the long term, how much does the company’s level of earnings (cash flows from operations) exceed its investment requirements? How certain is this level?
- Does the firm have enough financial reserves to maintain the dividend payout in periods when earnings are down or investment requirements are up?
- Does the firm have sufficient financial flexibility to maintain dividends if unforeseen circumstances wipe out its financial reserves when earnings are down?
- Can the firm quickly raise equity capital if necessary?
- If the company chooses to finance dividends by selling equity, will the increased number of stockholders have implications for the control of the company?
What is an acquisition?
The purchase of one firm by another (one company goes into the other). An acquisition occurs when one firm (the acquiring firm or bidder) completely absorbs another firm (the target firm)
What is a merger (amalgamation)?
The combination of two or more firms into a new legal entity (brand new company). Both (all) sets of shareholders must approve the transaction
What is a horizontal merger?
A merger in which two firms in the same industry combine
* Related business, transferring competitive valuable expertise, to lower costs
What are the benefits of merging?
- Manufacturing facilities, specialized skills, copyrights, production facilities, distribution channels, favourable reputation
Types of vertical merger
- Backward into sources of supply (buying its supplier, Walt Disney acquires Pixar)
- Forward toward end-users of final product
What is a vertical merger?
A merger in which one firm acquires a supplier or another firm that is closer to its existing customers
What is conglomerate merger?
- A merger in which two firms in unrelated businesses combined
- Different businesses face different risks, which can cancel each other out, lowering the overall risk of the company
- Diversification
Motivations for mergers and acquisitions
Synergy
What is synergy?
When we bring two companies together, we hope there is increased value that wasnt there prior
3 types of operating syngergies
- Economies of Scale
- Economies of Scope
- Complementary Strengths
What is economies of scope?
The combo of 2 activities reduce costs
- i.e. using a single distribution system to sell two lines of product instead of one
What is Economies of Scale?
Spreading fixed costs & geographic synergies
- i.e. all production can be done in one factory if businesses combine instead of 2, use excess capacity
What is complementary strengths?
One firm is more efficient in certain area(s) of operations than another. i.e. marketing oriented firm acquires a production oriented firm
Main motivations for mergers and acquisitions
- Operating Synergies
- Efficiency Increases
- Financing Synergy
- Tax Benefits
- Strategic Realignment
What is efficiency increases in terms of motivation?
New management team will be more efficient and add more value than what the target now has.
The combined firm can make use of unused production/sales/marketing channel capacity
What is financing strategy in terms of motivation?
- Reduced cash flow variability, overall business more stable, easier to get loans/financing
- Increase in debt capacity
- Reduction in average issuing costs
What is tax benefits in terms of motivation?
- Make better use of tax deductions and credits
- Using loses to lower taxes of past company
What is strategic realignment in terms of motivation?
Permits new strategies that were not feasible prior to the acquisition. The acquisition of new management skills, connections to markets or people, and new products/services
What are the two intents of legislation?
- Transparency – Information Disclosure
- Fair Treatment
What is transparency?
To ensure complete and timely information be available to all parties while at the same time not letting this requirement stall the process unduly.
What is fair treatment?
- To avoid oppression or coercion of minority shareholders.
- To permit competing bids during the process and not have the first bidder have special rights. (In this way, shareholders have the opportunity to get the greatest and fairest price for their shares.)
- To limit the ability of a minority to frustrate the will of a majority. (minority squeeze out provisions)
Steps in the securities legislation
- 10%: Early warning
- 20%: Takeover bid
- 50.1%: Control
- 66.7%: Amalgamation
- 90%: Minority Squeeze-Out
What is early warning?
10%
* When a shareholder hits this point a report is sent to OSC
* This requirement alerts other shareholders that a potential acquisitor is accumulating a position (toehold) in the firm.
What is takeover bid?
20%
* Not allowed further open market purchases but must make a takeover bid
* This allows all shareholders an equal opportunity to tender shares and forces equal treatment of all at the same price.
* This requirement also forces the acquisitor into disclosing intentions publicly before moving to full voting control of the firm.
What is control?
50.1%
* Shareholder controls voting decisions under normal voting (simple majority)
* Can replace board and control management
What is the takeover bid process?
- Takeover circular sent to all shareholders.
- Target (company someone is trying to acquire) has 15 days to circulate letter to shareholders with the recommendation of the board of directors to accept/reject.
- Bid must be open for 105 days following public announcement, subject to target board’s ability to reduce the bid period to at least 35 days.
What is amalgamation?
66.7%
Can approve amalgamation proposals requiring a 2/3s majority vote (supermajority)
What is minority squeeze-out?
90%
Once the shareholder owns 90% or more of the outstanding stock minority shareholders can be forced to tender their shares.
This provision prevents minority shareholders from frustrating the will of the majority.
How muchg does a competing bid increase the takeover window?
By 10 days and shareholders during this time can withdraw authorization and accept the competing offer
Tender offer facts
- Tender offer price cannot be for less than the average price of share that the acquirer bought shares in the previous 90 days. (prohibits coercive bids)
*If more shares are tendered than required under the tender, everyone who tendered shares will get a prorated number purchased.
What is a friendly acquisition?
- Both parties working together
- The acquisition of a target company that is willing to be taken over.
- Usually, the target will accommodate overtures and provide access to confidential information to facilitate the scoping and due diligence processes.
Friendly acquisition steps
- Starts when the target voluntarily puts itself into play
- Target uses an investment bank to prepare an offering memorandum
- May set up a data room and use confidentiality agreements
- A signed letter of intent (usually includes a no-shop clause and a termination or break fee)
- Legal team checks documents.
What is a hostile takeover?
- A takeover in which the target has no desire to be acquired and actively rebuffs the acquirer and refuses to provide any confidential information.
*The acquirer usually has already accumulated an interest in the target (20% of the outstanding shares) and this preemptive investment indicates the strength of resolve of the acquirer.
What is the hostile takeover process?
- Slowly acquire a toehold by open market purchase of shares at market prices without attracting attention.
- File statement with OSC at the 10% early warning stage while not trying to attract too much attention.
- Accumulate 20% of the outstanding shares through open market purchase over a longer period of time
- Make a tender offer to bring ownership percentage to the desired level (either the control (50.1%) or amalgamation level (67%)) - this offer contains a provision that it will be made only if a certain minimum percentage is obtained.
What are some market clues to potential outcome of a hostile takeover attempt?
- Market price jumps above the offer price
- Market price stays close to the offer prices
- Little trading in the shares
- Great deal of trading in the shares
What are the defensive tactics within a hostile takeover?
- Shareholders Rights Plan
- Selling the Crown Jewels
- White Knight
What is Selling the Crown Jewels?
- The selling of a target company’s key assets that the acquiring company is most interested in to make it less attractive for takeover.
- Can involve a large dividend to remove excess cash from the target’s balance sheet.
What is Shareholders Rights Plan?
- Known as a poison pill or deal killer
- Gives non-acquiring shareholders the right to buy 50 percent more shares at a discount price in the event of a takeover. Makes acquisition more expensive.
What is White Knight?
The target seeks out another acquirer considered friendly to make a counter offer and thereby rescue the target from a hostile takeover
What is globalization?
The removal of barriers to free trade and the closer integration of national economies
What is a multinational corporation?
A business firm that operates in more than one country but is headquartered or based in its home country
Who are multinational corporations owned by?
A mixture of domestic and foreign stockholders
Who are transnational corporations managed by?
Transnational corporations, regardless of the location of their headquarters, are managed from a global perspective rather than the perspective of a firm residing in a particular country
What are the six factors that cause international business transactions to differ from domestic deals?
- The uncertainty of future exchange rate movements
- Differences in legal systems and tax codes
- While English is the official business language, it is not, however, the world’s social language.
- Cultural views also shape business practices and people’s attitudes toward business.
- An economic system determines how a country mobilizes its resources to produce goods and services needed by society, as well as how the production is distributed.
- Country risk refers to political uncertainty associated with a particular country. (change in tax laws, restrictive labour laws, local ownership, tariffs and quotas, disallow any cash from subsidiary to parent)
Basic principles of managerial finance
- The basic principles of managerial finance remain the same whether a transaction is domestic or international.
- The time value of money is not affected by whether a business transaction is domestic or international.
- The same models are used for valuing capital assets, bonds, stocks, and entire firms
What is the foreign exchange market?
A group of international markets connected electronically where currencies are bought and sold in wholesale amounts
What is spot rate?
The rate at which one agrees to buy or sell a currency today
What is forward rate?
Established at the date on which the agreement is made and defines the exchange rate to be used when the transaction is completed in the future.
What is direct quotation method?
The amount of a home countries currency needed to purchase one unit of a foreign currency
What is indirect quotation method?
The amount of foreign currency needed to purchase one unit of the home countries currency
What is forward rate used for?
To manage risks/eliminate uncertainty- by contracting now to buy or sell foreign currencies at some future date, managers can lock in the cost of foreign exchange at the beginning of a transaction, and do not have to worry about the possibility of an unfavourable movement in the exchange rate before the transaction is completed
What does hedging a currency transaction mean?
To hedge means to engage in a financial transaction to reduce risk
What are cross rates?
Cross rates are exchange rates between two different currencies
What is international capital budgeting?
When a multinational firm wants to consider overseas capital projects, the financial manager faces the decision of which capital projects should be accepted on a company-wide basis.
When can cash flow problems arise?
When foreign governments restrict the amount of cash that can be repatriated, or returned, to the parent company.
What is exchange rate risk?
One of the problems with obtaining currency rate forecasts for use in analysis of capital projects is that many projects have lives of 20 years or more.
What are financial derivative securities?
Derive all or part of their value from another (underlying) security
Why do we trade indirect claims?
- Expand investment opportunities
- Lower cost
- Increase leverage
What are options?
Ceated by investors, sold to other investors (corporation of the underlying stock has no direct interest in the transaction)
What is a call?
Buyer has the right, but not the obligation, to purchase a fixed quantity from the seller (writer) at a fixed price up to a certain date
What is a put?
Buyer has the right, but not the obligation, to sell a fixed quantity to the seller (writer) at a fixed price up to a certain date
What is an exercise price?
The per-share price at which the common stock may be purchased or sold
What is an expiration date?
Last date at which an option can be exercised
* American- can exercise anytime up until the expiration date
* European- can exercise only on the expiration date
What is option premium?
The price paid by the option buyer to the writer of the option in order to purchase the option (applies for both put or call option)
How do options work?
- Call buyer expects the price of the underlying security to increase
- Call seller (writer) expects the price of the underlying security to decrease or stay the same
- Put buyer expects the price of the underlying security to decrease
- Put seller (writer) expects the price of the underlying security to increase or stay the same
- Possible courses of action
What are out-of-the-money options?
Out-of-the-money options should not be exercised immediately
* Call options: S < E
* Put options: S > E
What are in-the-money options?
Have a positive cash flow if exercised immediately
* Call options: Stock price (S) > Exercise price (E)
* Put options: S < E
When is an option at the money?
When stock price = exercise price
What is the Canadian clearing corporation?
The Canadian Derivatives Clearing Corporation
What is the instrinsic value?
The value of an option if today was the expiration date
Instrinsic Value of a Call Option
For a call, if the call option is at or out of the money (exercise price is more than market price), the intrinsic value is zero and the price of the option is based entirely on its speculative appeal
If the call option is in the money (exercise price is less than the market price), the intrinsic value is the difference between the stock price and the exercise price
What is an unconvered option writer/naked option writer?
One who does not have their position “covered” in the underlying stock
Unlimited potential loss
Intrinsic Value of a Put Option
For a put, if the put option is at or out of the money (exercise price is less than market price), the intrinsic value is zero and the price of the option is based entirely on its speculative appeal
If the put option is in the money (exercise price is more than the market price), the intrinsic value is the difference between the exercise price and the stock price
What are covered calls?
When you write/sell a call option while owning the underlying stock
What are protective puts?
- A strategy involving the purchase of a put option as a supplement to a long position in an underlying asset
- Owning a stock and buying a put for the same stock
- The put acts as insurance against a decline in the underlying stock price, guaranteeing an investor a minimum price at which the stock can be sold.
- In effect, the insurance acts to limit losses or unfavourable outcomes
What are option valuation in terms of time value?
Option prices almost always exceed intrinsic values, with the difference reflecting the option’s potential appreciation, referred to as the time value
* The actual source of value is volatility in price
* Price volatility decreases with a shortening of the time to expiration, hence the term time value
* Because buyers are willing to pay a price for potential future stock price movements, time has a positive value- the longer the time to expiration for the option, the more chance it has to appreciate
* As expiration approaches, the time value of the option declines to zero
What is time value?
The difference between the intrinsic value of an option and its market price
Time value = option price – intrinsic value
What are the future markets?
Spot market, forward market, futures market
What is the spot market?
Price refers to item available for immediate delivery
What is the forward market?
Price refers to item available for delayed delivery
What is a future market?
- Sets features (contract size, delivery date, and conditions) for delivery
- An obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today
- Futures markets are, in effect, organized and standardized forward markets
What are the future market characteristics?
- Centralized marketplace allows investors to trade with each other
- Performance is guaranteed by a clearing house
What are financials?
Foreign currencies as well as debt and equity instruments
What are commodities?
Agricultural, metals, and energy related
What is a clearing corporation?
- A corporation separate from, but associated with, each exchange
- Exchange members must be members or pay a member for these services
* Buyers and sellers settle with clearing corporation, not with each other - Helps facilitate an orderly market & ensures fulfillment of each contract
- Keeps track of obligations
- On the other side of all transactions
What are the mechanics of trading?
Seller and buyer agree to take or make delivery on a future date at a price agreed on today
* Short position (seller) commits a trader to deliver an item at contract maturity
* Long position (buyer) commits a trader to purchase an item at contract maturity
What are hedges?
- At risk with a spot market asset and exposed to unexpected price changes
- Buy or sell futures to offset the risk
- Used as a form of insurance
- Willing to forgo some profit in order to reduce risk
- Hedged return has smaller chance of low return but also smaller chance of high return
